PIMCO Sees An End To The Currency Wars

One of the prevailing themes in FX land over the past year, courtesy of prevalent central bank intervention in the monetary arena, has been a pervasive conflict among the world's money printers whereby those who have been unable to keep up with the Fed's fiat printing, have been engaging in direct open market purchases of USD to keep their own currencies lower, and thus promote exports, etc. The fact that currency exchange rates have been as unstable as they have since the start of QE 1, and especially QE 2, is in our opinion, a main reason for the outflow of trading volume from equity markets and into venues that exhibit the kind of volatility desired by short-term speculators, such as FX. Today, PIMCO's Clarida, in an informative Q&A, proposes that the currency wars we have all grown to love so much over the past year, are coming to an end. The implications of this assumption are indeed substantial. While we do not agree with the assessment, it does merit further exploration, especially since it touches on PIMCO's outlook for the dollar: "In our baseline case we do
not see the dollar being supplanted as the global reserve currency in
the next three to five years. If foreign central banks were to decide
that they did not want to hold dollars as a reserve, they would have to
hold some other currency. And right now there is not a single viable
alternative to the dollar. Aside from the 60% that I mentioned earlier,
global reserves include about 30% in euros and the rest is mixed. Given
current circumstances in Europe, we would not expect the euro to
supplant the dollar." Oddly, there is still no mention of such currency alterantives as precious metals, which as the Erste Bank report noted yesterday, has already set the groundwork for a return to real sound money. Much more inside.

International
capital is flowing to countries with good growth prospects and to
countries with central banks confident enough to raise interest rates.

Certain nations are placing controls on capital or intervening in
currency markets with an eye to maintaining economic competitiveness.

We see central banks in the U.S. and the U.K. winding down monetary
stimulus that has exacerbated the situation. Also, we see potential for
emerging market currencies to appreciate, and that may give developed
nations a boost.

Nations generally benefit when their currency valuation is low enough to
assist domestic industry, making their exports cheap and imports
expensive. But when a trading partner intervenes in currency markets to
enforce a low valuation, then international tension may arise.

In
the fourth of a series of Q&A articles accompanying the recent
release of PIMCO's Secular Outlook, portfolio manager Richard Clarida
discusses PIMCO’s outlook on currencies and argues that global currency
tensions may ease in the years ahead.

Q. Could you
discuss efforts some nations appear to be taking to direct the exchange
value of their currencies to favor domestic industry? Is this a source
of long-term global tension (previously some media reports spoke of
“currency war”)?

Clarida: Taking a
step back, our secular outlook for the next three to five years is for a
two-speed global recovery with emerging markets (EM) leading the way.
One natural consequence is that international capital is flowing to
countries with good growth prospects and also to countries with central
banks that have the confidence to raise interest rates. Much of the
focus, rightly, has been on emerging markets, but developed nations such
as Australia, Canada and Norway have been hiking interest rates, and
their commodity producers are benefiting from booming emerging growth.

Some
countries are resisting the upward pressure that these capital flows
are putting on their exchange rates. They are placing controls on
capital or intervening significantly in currency markets with an eye to
maintaining economic competitiveness. We do see this dynamic as a source
of long-term global tension, but we believe it is a tension that most
likely will be manageable. For example, we see central banks in the U.S.
and the U.K. winding down monetary stimulus that has exacerbated the
situation; rate hikes could be on the horizon in 2012.

Q. Could you elaborate on how PIMCO sees this issue playing out?

Clarida: If
indeed emerging economies are to continue to be centers of global
growth, then at some point we believe they will move toward more of a
local-demand-driven economic model and away from an export-reliant
model. We see currency adjustment as part of that rebalancing.

Let
me explain this dynamic. Think of an emerging economy with very rapid
productivity growth – the amount of goods and services it can produce
each year is expanding. If this hypothetical country relies on export
demand, it requires a relatively weak exchange rate to absorb more and
more supply. If this country fears export demand is tapering off, it may
shift focus and begin nurturing domestic demand – selling local goods
to local customers. But if goods and services shift to domestic demand
that creates scarcity on the global market and prices rise. So to
maintain domestic demand the emerging nation allows its currency to
appreciate, which enables domestic consumers to compete globally.
Theoretically, this eases global tensions and gives developed nations a
boost: since their currencies are relatively cheaper their exports
become more competitive.

Q. What does PIMCO mean when it speaks of a trilemma dilemma?

Clarida: The
trilemma is a fundamental concept in international finance developed by
Nobel laureate economist Robert Mundell, and the basic idea is that for
any national economy operating in a broader global economy, there are
three desirable outcomes. National leaders want an independent monetary
policy that suits domestic circumstances. They want to benefit from the
free flow of capital, especially capital inflows directed toward
economic investment. And they want a stable exchange rate.

This
trio is called a trilemma because theory and experience suggest at most
a nation can only achieve two of those objectives. Thus, international
policy making is always about trading off the desirability of exchange
rate stability, monetary independence and capital flows. The U.S., for
example, has had an independent central bank and certainly benefits from
an open capital market reflected in our current account deficit – we
borrow from the rest of the world. But the dollar fluctuates not only
with U.S. events but also with global ones. China, on the other hand,
has a very stable exchange rate because they manage it, and their
central bank has some leeway to influence domestic interest rates. But
China has restricted capital mobility.

Q. Is the U.S.
dollar slipping as the world’s reserve currency? Which currency or
currencies will dominate global commerce in the years ahead?

Clarida: The
dollar’s preeminence dates to the end of World War II with the Bretton
Woods global agreement on monetary management. That formal system
unwound in the early ‘70s, but the dollar has continued to serve as the
global reserve currency. But note that the share of dollars in global
central bank portfolios has been declining slowly for the last eight to
10 years. According to the International Monetary Fund, about 60% to 65%
of global reserves held by emerging nations are in the form of dollars,
down from about 70% a decade ago.

In our baseline case we do
not see the dollar being supplanted as the global reserve currency in
the next three to five years. If foreign central banks were to decide
that they did not want to hold dollars as a reserve, they would have to
hold some other currency. And right now there is not a single viable
alternative to the dollar. Aside from the 60% that I mentioned earlier,
global reserves include about 30% in euros and the rest is mixed. Given
current circumstances in Europe, we would not expect the euro to
supplant the dollar.

I should point out that although there are
privileges that accrue to the provider of the global reserve currency
such as cheaper access to global funds, there are also obligations. In
periods of financial turmoil or geopolitical turmoil, we tend to see the
dollar become more volatile and to appreciate sharply in the
flight-to-quality trade. I suspect there are not many policymakers in
the world that would like that loss of control and certainty about their
currency valuation.

Q. How should investors approach
currency investing both in terms of hedging and seeking investment
returns? What are the opportunities and risks?

Clarida: At
PIMCO, we like to separate in our own minds an investment decision on a
security with a separate decision on whether we want to take the
related currency bet. In today’s markets, investors are generally able
to hedge currency exposure.

Also, certain PIMCO strategies may
invest directly in currencies. Broadly, our approach to investing in
currencies is to think of them as a way to express our macro views about
opportunities in a number of countries.

With our New Normal
worldview of headwinds to growth in developed markets and tailwinds in
emerging markets, we now generally look at emerging market and G-10
currencies simultaneously and with the same analytical framework. As I
discussed earlier, we anticipate EM policymakers will allow their
currencies to appreciate in the years ahead as they nurture domestic
consumption. And in contrast to the ‘80s and ‘90s, in recent years EM
currencies have been less volatile than G-10 currencies. Thus, EM
currencies can be attractive opportunities.

Of course, as with
any financial investment, there are risks to investing in currencies.
The primary risk, in our view, is that there are periods in which
volatility spikes and in which there are potentially significant drops
in a currency’s relative valuation. There is a saying in the foreign
currency markets that currency trades work until they don’t. And so
certainly anyone thinking of investing in currencies should also
consider if portfolio managers are appropriately factoring in such tail
risk. That is certainly a focus at PIMCO.